Here's Why Hormel Foods (NYSE:HRL) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Hormel Foods Corporation (NYSE:HRL) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Hormel Foods

What Is Hormel Foods's Debt?

The chart below, which you can click on for greater detail, shows that Hormel Foods had US$3.31b in debt in July 2023; about the same as the year before. On the flip side, it has US$686.5m in cash leading to net debt of about US$2.62b.

How Strong Is Hormel Foods' Balance Sheet?

We can see from the most recent balance sheet that Hormel Foods had liabilities of US$2.32b falling due within a year, and liabilities of US$3.39b due beyond that. On the other hand, it had cash of US$686.5m and US$793.7m worth of receivables due within a year. So it has liabilities totalling US$4.23b more than its cash and near-term receivables, combined.

Hormel Foods has a very large market capitalization of US$21.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Hormel Foods's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its strong interest cover of 25.4 times, makes us even more comfortable. Unfortunately, Hormel Foods's EBIT flopped 12% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hormel Foods can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Hormel Foods produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On our analysis Hormel Foods's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. To be specific, it seems about as good at (not) growing its EBIT as wet socks are at keeping your feet warm. Considering this range of data points, we think Hormel Foods is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Hormel Foods insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.